Management Consultant

A business strategist and economist with more than 25 years experience in management consulting, business and government. Specialties include Retail Lifecycle Management, supply chain strategy and operations, and business transformation.

Friday, October 31, 2008

National Public RadioIn a previous post I mentioned, without much explanation, that credit default swaps (CDS) were instrumental in creating the 2008 credit crisis. As it happens, Alex Blumberg has done some of the clearest reporting on CDS for a National Public Radio (NPR) program, "This American Life."

Credit default swaps, which have become featured players in the troubled asset drama, are over-the-counter contracts that have been widely used to hedge investors against the risk of mortgage-backed securities. Unlike insurance policies, however, they do not require that either party actually own the assets being protected. As one of their inventors, Gregg Berman, explains:

It is exactly like buying insurance for a house you don't own.

And that is the very definition of moral hazard. Speculators can enter the market to bet against houses they consider at risk, thereby creating a market for arson. And bet they did.Berman and Satyajit Das, a risk consultant, were interviewed for the story, How Credit Default Swaps Spread Financial Rot.

Das says that during his time in the industry, the amount of credit default swaps that were speculative grew to dwarf the amount that were used for insurance...There are $5 trillion worth of bonds issued in the world, but the total amount that people have bet on those bonds is $60 trillion.

Because they were traded over-the-counter, CDS have been unregulated and are nearly invisible to investors. We now know that many of the obligations to cover mortgage-backed securities are held by AIG, an insurance firm. On 16-Sept-08 the U.S. Treasury seized control of AIG and has now invested about $122 billionto prop it up.

This week I received a letter from AIG offering me an Essential Health insurance plan. The envelope exclaimed:

You Can help get greater control of your medical expenses. (And for less than you think.)

Sunday, October 19, 2008

Economists, bloggers and amateur historians will read with interest the rich exchange of ideas on the Paulson bailout plan instigated by Christopher Carroll, the economist from Johns Hopkins University, on the Economists' Forum blog of the Financial Times, TARP and the Ruin of Pompeii: An Analogy.

Professor Carroll poses a simple model of a financial system in crisis that results when an under-capitalized bank holding mortgages of the citizens of Pompeii learns that its balance sheet has been compromised by an unforeseen event, the eruption of Mount Vesuvius. Writing during the critical days immediately following passage of the Emergency Economic Stabilization Act of 2008, Carroll and a cast of contributors try out a number of policy alternatives as they enrich the model, in the process making it ever more analogous to the present situation.

Mr. Carroll takes the question directly to Secretary Paulson, wondering rhetorically why the classical, free-market solution--let the banks fail--would not be more sensible than the approach initially suggested by Paulson, by which agents of the U.S. Treasury would inject capital into financial institutions by purchasing troubled assets at prices to be set by auction on exchanges to be named later. Carroll doubts that any auction can establish the real value of these securities and thus suggests that policy-makers consider direct investments in bank equity.

The contributors poke at Carroll's model and his history, variously:

Defending TARP (Troubled Asset Relief Program) as a mechanism for creating liquidity in the short term

Introducing complexity (e.g., suppose Pompeii's mortgage had been insured by entrepreneurs at Vandelsbank)

Considering the fallout of market failure ("it will trigger a run on all the other banks in the Empire, putting millions of potential tourists to the new Pompeian ruins out of work and unable to afford the trip") and

Noting that Titus and not the despised Nero was Emperor at the time of the Eruption

One commentator remarked:

How strange to call this plan “TARP” when the old Romans used to say “The Tarpeian Rock is not far from the Capitol.”(Editor: Following his link, one finds that the Tarpeian Rock is the precipice from which ancient Romans flung traitors, murderers, and those "cursed by the gods.")

Within days of Carroll's article the finance ministers of the G7, led by the UK, announced plans to battle the world liquidity crisis by directly injecting capital into their respective banks. Secretary Paulson, in what seemed a remarkable turnabout, shifted his policy focus from purchase of troubled assets to direct investment in financial institutions. Calling a meeting of the leaders of the nine largest U.S. banks, Paulson called on each of them to contract immediately with the US government for a direct infusion of federal cash in the form of escalating loans, along with warrants for preferred stock and limits on executive pay. In dramatic reporting for the The New York Times, Mark Landler and Eric Dash wrote:

In addition to the capital infusions, which will be made this week, the government said it would temporarily guarantee $1.5 trillion in new senior debt issued by banks, as well as insure $500 billion in deposits in noninterest-bearing accounts, mainly used by businesses.

All told, the potential cost to the government of the latest bailout package comes to $2.25 trillion, triple the size of the original $700 billion rescue package, which centered on buying distressed assets from banks.

Carroll and his contributors have provided a masters class in political economy, open to the public. In it we read the thinking behind policy as it is crafted and revised in real time. More than that, we are witness to the development of economic theory. Hypotheses are set out. Models are postulated, tested and examined for implications. (One commentator, Professor Perry Mehrling of Columbia University, interprets the technical balance sheet entries of the U.S. Federal Reserve Bank on October 1, 2008 to conclude that the Fed had run out of ammunition to battle the crisis.) Consequences of policy provisions, with their inevitable compromises and disappointments, are weighed against the risks of doing nothing.

For the moment, the consensus view that banks should be forced to recapitalize despite concerns about damage to free market principles, seems to be carrying the day. And it should.

Direct investment in bank reserves is considerably more efficient than purchase of troubled assets in producing liquidity because such action dramatically improves banks' reserve ratios.

Under the latest plan banks remain responsible for their balance sheets.

The government has agreed to charge a fair price for the required capital investment and has provided banks incentives for banks to buy back the the government's stake through privately financed equity. (The Treasury will purchase preferred stock paying 5% dividends initially, but rising to 9% on shares held beyond five years. Treasury will also get warrants to purchase common shares equivalent to 15% of its initial investment.)

Compulsory action against the largest banks provides cover for others to volunteer for the program without suffering the financial taint of appearing weak. Without compulsion, which bank would have been first to appear at the government's lending window? Which executives would have volunteered to cap their own pay?

The crisis is not over and the full implications are not well known. Governments around the world will need to act responsibly and in coordination to bring the world economy to a soft landing.

Friday, October 3, 2008

The U.S. House is expected to vote today on the Senate version of the bailout plan, HR1424, the Emergency Economic Stabilization Act of 2008. Following two weeks of intense scrutiny, debate, political wrangling and even some soul searching, Congress seems ready to pass a bill that offers hope of cutting the Gordian knot strangling credit markets. Action could not come too soon.

The bill, summarized here, has undergone some important changes over the past two weeks and its scope and intent have been clarified. Initially dubbed the "bailout plan" or the "Troubled Asset Rescue Plan," the bill's original intent was to grant sufficient authority to the U.S. Treasury to take steps that would avert panic in the credit markets. The most controversial portion of the plan, would create a:

Troubled Assets Relief Program (TARP), under which the Secretary of the Treasury would be authorized to purchase, insure, hold, and sell a wide variety of financial instruments, particularly those that are based on or related to residential or commercial mortgages issued prior to March 14, 2008 - CBO Director Peter Orszag

As Joe Nocera reported Oct. 1 in the New York Times, large investors fearing imminent bank failures were cashing out even very liquid assets and moving them between institutions. Witnessing what appeared to be the first stages of a full-blown run on the banks, Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke sounded the alarm, outlined emergency measures, and began to rally the political forces required. The name of the rescue plan was impolitic (why should the Public be troubled about bank assets?), details of the actions required were sketchy, estimates of the cost were imprecise, and oversight measures were missing entirely, but the critical first steps had been taken. The body politic was in motion.

On Monday, 29-Sept-08 the first bill sculpted from the plan, HR3997 (summarized here), failed to pass the House of Representatives, despite the incorporation into the bill of substantial improvements and clarifications to the plan, particularly in the area of oversight. Then, with unusual speed the Senate crafted the new bill, HR1424, adding two unrelated divisions designed to bring more Members of Congress on board. The new Division B, The Energy Improvement and Extension Act of 2008, and Division C, Tax Extensions and Alternative Minimum Tax Relief, would add approximately $112 billion to deficits over the next ten years. More importantly, they provide political cover to Members of Congress who will have to explain to constituents in this month before the election how they could enact an expensive and unpopular bailout plan.

It now seems clear that passage of the bill is necessary, but not sufficient to avoid a major recession. By insuring bank deposits and money market funds up to $250,000 per account, the measure substantially reduces the risk of runs on banks by depositors and will forestall a substantial amount of unproductive movement of deposits from bank to bank and account to account. This insurance provision will also calm investors in those banks.

TARP provides a mechanism for the Treasury to inject capital into financial institutions, transforming unproductive, illiquid assets at participating institutions into cash that can then support new loans.

Investors should watch closely the provisions of the bill relating to "mark-to-market" accounting requirements, which were instituted earlier this year to provide more transparency to financial reports. The bill would authorize the SEC to restate those requirements and require the Commission to reconsider them and report its findings back to Congress. The practical effect of these provisions will be to improve the balance sheets of financial institutions holding devalued assets, such as mortgage-backed securities, thereby allowing them to make more loans against those assets.

In combination, these provisions are designed to calm investors, create liquidity, and buy time for Treasury to help troubled institutions recapitalize.

The next Administration will have to preside over a period of further consolidation of financial institutions as it tries to keep mounting federal debt from further slowing the economy. It must also address the accounting rules that have confused investors and regulators alike about the underlying values of American assets and corporations.

A detailed analysis of the legal implications of the Act has been provided by the firm of Davis, Polk & Wardwell (available here).

Wednesday, October 1, 2008

Mr. Biciocchi is a founding Partner in C3 Consulting, which focuses on developing consumer centric solutions in Supply Chain and IT for Retail and Consumer Goods firms.

Prior to C3, Steve has been providing thought leadership, senior client relationships and hands-on direction of major projects in business and supply chain strategy, customer service, business process redesign and technology as Managing Director of CSC’s US Retail and Consumer Goods industry practice.

Before beginning his consulting career 20 years ago, Mr. Biciocchi worked in industrial engineering, manufacturing, finance and logistics roles for Clarke America, Burroughs/Unisys Corporation and Zayre Corporation.

Mr. Biciocchi has a BS degree in Industrial Engineering from Northeastern University in Boston and an MBA from Salisbury State University in Maryland.

To learn more about our work in consulting, please see our Profile, download a brochure about our Practice, or check out our Case Studies.